New Imbalances Will Threaten Global Recovery

Global imbalances are about to jump again. New estimates from the Organization for Economic Cooperation and Development suggest that the sharp decline in the exchange rate of the euro, along with tepid European growth, will produce eurozone surpluses of at least $300 billion (251 billion, £208 billion) annually within the next few years. The tightening of fiscal policies throughout Europe in response to the crisis, along with the new balanced budget amendment in Germany, will both depress domestic demand and require easier monetary policy that will weaken the euro further.

No one would accuse the eurozone of competitive devaluation. However, there is considerable satisfaction throughout Europe with the weak currency. Martin Wolf of this newspaper has already characterized Europe's de facto strategy to export its way out of stagnation as "stumbling into a beggar-my-neighbor policy."

Whatever the intent, these European developments will have effects similar to the overt steps taken by other major countries to enhance their trade competitiveness. The most extreme case is the massive intervention by China and surrounding countries to keep their currencies severely undervalued. Other emerging markets are likewise seeking to expand further their war chests of foreign exchange by running large external surpluses. Switzerland has intervened substantially to hold its currency down. The eurozone has joined this "new mercantilism" and the result will be a sharp rise in global imbalances.

The counterpart increases in deficits will again accumulate mainly in the United States as no other country could attract the requisite financing. The large deficit countries within the eurozone must reduce their imbalances. Along with the large surpluses of China and other Asian countries, the new European surpluses will probably double the American current account deficit beyond its previous record of $800 billion in 2006. The United States could then maintain its recovery only by continuing to run large budget deficits and again tolerating debt-financed consumer demand. This is the opposite of the rebalancing strategy agreed by the Group of 20 leading economies as critically important for sustaining global expansion and reiterated by its finance ministers last weekend.

Many regard this scenario as a desirable resolution of the current European crisis. Investor proclivities to buy Treasury securities and dollars could finance the American deficits for a while. The United States would provide the global collective good, as in the past, by accepting increased dollar overvaluation and further increases in its external debt and deficits.

There are three glaring problems with this vision, however, all centered on the United States. First, the sharp escalation of its own domestic and international imbalances would intensify the risk of future market attacks on the dollar and US financial assets. As soon as Europe and other alternatives regain their acceptability to investors, the unsustainability of the US situation would return to center stage at even more dangerous levels.

Second, the higher imbalances themselves could sow the seeds of a new financial crisis just as they helped sow the seeds of the last crisis. Such huge inflows of foreign capital would keep US financial markets excessively liquid, hold interest rates down, promote underpricing of risk, and thus again generate irresponsible lending and borrowing.

Third, a renewed explosion of the US trade deficit could well trigger the outbreak of protectionist trade policies that has been largely avoided to date. With unemployment remaining very high, job losses to the "new mercantilism" abroad are likely to incite strong political reactions. The virtual absence of a positive trade policy under President Barack Obama has created a dangerous vacuum in which new import restrictions, especially aimed against "unfair exchange rates," could readily prevail.

At its upcoming summits in Toronto and Seoul, the G-20 must adapt its rebalancing strategy to prevent this new threat to continued recovery and lasting global stability. Surplus Germany, along with China and Japan, must stimulate domestic demand. China must let the renminbi strengthen substantially. Joint intervention in exchange markets should prevent or reverse any significant further fall in the euro. Additional allocations of special drawing rights would enable countries to build reserves without running trade surpluses.

Most importantly, the United States must convince the world it is unwilling again to become the consumer and borrower of last resort. Only then will other countries stop relying on rising trade surpluses and become serious about generating domestic demand. Such a US strategy will of course focus on medium-term fiscal correction and increased private saving. But it will also have to end the chronic dollar overvaluations of the last 30 years, and euro depreciation along with continued renminbi manipulation will inevitably push currency issues back to the top of the global agenda.